The Incidental Economist

The leadoff article in the Competition Policy International Journal‘s (paywall) recent “focus issue” on behavioral economics is a primer on the literature regarding systematically irrational behavior by firms and its implications for competition law and policy. The topic is in itself unusual, as the authors Mark Armstrong and Steffan Huck note, inasmuch as a large part of the research on sub-optimal decision making focuses on consumers. Firms, by contrast, are frequently presumed–especially by courts and policymakers–to be model rational actors. The results surveyed by the authors strongly suggest that this is very frequently not the case.

One example with significant practical consequences is the manner in which cartel formation deviates from theoretical models under the influence of different enforcement regimes. Game theory predicts the ineffectiveness of leniency programs, such as those employed by competition authorities in the US and Europe, under which lower penalties or complete amnesty are given to the first participant to turn in a price-fixing conspiracy. Theories postulate that leniency can even encourage cartel formation because rational participants can use it as an enforcement mechanism to punish cheaters. But experimental results have found lower prices and incidence of cartel formation under leniency. The reasons for these deviations from rational maximization are speculative, but the fact that they occur is highly relevant to the formulation of competition policy.

Similar results are also relevant to the emerging practice by US courts of evaluating and often dismissing antitrust complaints based on their facial “plausibility” without allowing any investigation of the actual facts underlying a claim:

Courts and regulators in some jurisdictions may not consider seriously conduct (such as predatory pricing, for instance) which does not appear to make “business sense” according to their judgment. Leslie reports that “if a plaintiff’s complaint describes a conspiracy that the judge concludes is irrational, then the court rules that the conspiracy must not have happened as a matter of law, regardless of the evidence presented by the plaintiff to support its claim.” In the light of the theories and evidence reported in this article, we suggest that a dogmatic attitude towards the pervasiveness of business rationality may lead to instances where harmful behavior goes unpunished.

I will be watching for how lawyers use the growing body of behavioral economic evidence in this area to oppose dismissal in antitrust cases, and whether courts will pay it any heed.

Among the many excellent points made by Econgirl in her post this week discussing a recent NYT op-ed piece by George Loewenstein and Peter Ubel criticizing the use of behavioral economics to formulate policy is the following spot-on summation of the relationship between behavioral and traditional microeconomics:

First, the divide between behavioral economics and traditional microeconomics is not nearly as wide or as clear as [the Loewenstein and Ubel piece] implies. Put simply, the difference between traditional and behavioral economics is that traditional economics assumes that individuals are always able to maximize their long-term utility and aren’t swayed by silly things like discrepancies between short-term and long-term happiness, the framing, wording or context of their choices, self-control problems, cognitive limitations and the like, and behavioral economics…well, doesn’t.

In other words, behavioral economics is more or less traditional microeconomics without the simplifying assumptions.

This characterization put me in mind of a more general postulate about the relationship between predecessor and successor theories in science that Niels Bohr called the principle of correspondence.  Bohr derived his correspondence principle in the first instance from the observation that the predictions of quantum mechanics correspond to those of classical mechanics when quantum values are sufficiently large.  But the principle is equally applicable to the relationship between other successive theories, such as between Newtonian gravity and relativity, which yield the same predictions when gravity is sufficiently weak.

Bohr believed it was a necessary feature of the growth of scientific knowledge that the predictions (if not the theoretical interpretation) of previously successful scientific theories should in every instance correspond to a special case of the theories that succeed them.  The necessity of this relationship arises from the fact that if the predecessor theory had not made correct predictions for at least some realm of experience, however limited, it would never have been successful.  And a successor theory must always account for its predecessor’s success by yielding the same predictions within that realm.

Surely by virtue of having just read Econgirl’s post, I was attuned to the correspondence principle when, working through my backlog of Econtalk podcasts, I finally got around to listening to a discussion from last February between Russ Roberts and Larry White on Hayek and money.  And I was struck by how little disagreement their talk attributed to Hayek and Keynes about the dynamics of the expansionary phase of the business cycle.  Where they parted company was over the persistence of depressed economic conditions long after a credit or technology bubble has burst.  Austrianism fell into obscurity over its lack of a plausible explanation for this phenomenon, while the Keynesian synthesis occupied the field of macroeconomics for the better part of a century and into the present day.

But as much as these two schools of economic thought are cast in opposition to each other, it seems that their predictions more or less correspond given the assumption of normal economic times.  And if the current Austrian revival produces a superior theory of recession and recovery, the correspondence principle requires that it account for as much success as today’s mainstream macroeconomics can honestly claim.

I suppose it’s Fannie Mae’s right to deny new mortgages to so-called “strategic defaulters,” as it announced this week.  But I must admit as a lawyer that the moral tinge of the discussion about borrowers walking away from their underwater mortgages has left me scratching my head.

The prevailing “economic theory of contract” that we all learned in law school teaches that when a party to a contract is better off breaching (and paying any damages owing on that account), it ought to do so.  The breach in this case is said to be economically efficient, inasmuch as the breaching party is clearly better off, and the non-breaching party is no worse off relative to whatever it bargained for.  Such an “efficient breach” is welfare maximizing as between the parties, because the sum of their total welfare is greater than if the breaching party had performed.

Now in the case of a borrower defaulting on a non-recourse home loan (i.e., one in which the lender has no right to pursue the borrower’s personal assets if the value of the home is insufficient to satisfy the outstanding balance of the mortgage), you might say that the lender is clearly worse off receiving the home when the borrower defaults than receiving the stream of payments if the borrower had not.  But the risk that the lender would be left with the home instead of the stream of payments if the borrower defaulted, for any reason, is one that is allocated to the lender under such a contract, and is presumably reflected in the price (i.e., the interest rate and other costs) that the lender charged for the loan.  The lender loses nothing when it gets exactly what it bargained to receive in relation to a risk that it was paid to voluntarily assume.

Obviously, there are complications to this idealized picture in the real world.  Large scale defaults threaten broad negative consequences for housing markets and the financial system, and these effects are magnified by the leveraging of underlying mortgages in the securitization and derivatives markets that grew up around the housing bubble.  But it is unclear to me why borrowers should bear any special moral burden to carry the cost of these sorts of systemic externalities.  And it seems ironic to me that entities like Fannie Mae, which are as responsible as any for creating the systemic risks that the default wave poses to the larger economy, are often as not the ones pushing the “strategic default” moral narrative.

After all, a deal’s a deal.

Uwe Reinhardt may be right to doubt, based on his own experience as a board member of both for-profit and non-profit hospitals, “that any hospital board or any hospital executive in the country would even dream of knowingly defrauding the United States government.”  But that’s not how Medicare and Medicaid billing fraud and overpayment generally happens.  Rather, as the the massive Columbia/HCA fraud of the 1990s illustrates, the role of hospital boards and executives in cultivating fraud is more likely to be the application of relentless and unrealistic pressure to increase profits, combined with lax oversight and indifference to how results are achieved.  Under these conditions, fraud (and its systematic rationalization) is something that grows organically within a company.

Nor are such dynamics a thing of the past.  Take, for example, the practice of “upcoding” — a form of diagnosis inflation in which procedures and patients are systematically assigned higher standardized Medicare reimbursement codes than they really warrant.  To give an example that figured prominently in the HCA fraud, a hospital can double its reimbursement for a simple pneumonia patient by classifying the patient’s condition as a complicated respiratory infection.  Silverman and Skinner (2004) identified a starkly greater incidence of such upcoding among for-profit hospitals compared to non-profits during the heyday of upcoding in the 1990s.  And the Center for Budget and Policy Priorities cites Centers for Medicare and Medicaid Services findings that upcoding persisted in the last decade:

In reviewing data from 2000-2003, CMS found an increase in patients being categorized as needing higher levels of care, but did not find a corresponding change in patients’ underlying health status or in the average amount of home health care resources used to treat them. CMS concluded that some of the changes in how patients were categorized likely reflected upcoding. Further analyses revealed that since 2000, the observed case mix — an indicator of the characteristics of the beneficiaries being served by home health agencies, such as age, gender, and health status — increased by roughly 13 percent. However, more than 90 percent of this increase was a result of changes in documentation and coding practices rather than changes in patients’ medical needs.

In light of these findings, its easy to see how measures designed to maximize legitimate reimbursements can drift into systematic overcharging without any conscious decision by management or directors to cross the line.  The internal controls that Reinhardt decries as burdensome and unnecessary cost centers are in fact a necessary immune system in economic organisms that are metabolically inclined toward fraud.  While these costs (and those of Senator Coburn’s absurd secret inspector corps that the President has sadly embraced) can’t reasonably be avoided in the existing fee-for-service Medicare regime, perhaps further progress toward outcome-based reimbursement in the direction set by the Senate health care bill can move us in that direction.

When assessing the effects of market concentration on competition, antitrust authorities look not just at how many competitors there are in a market, but also how they compete.  In one standard model, called Cournot competition, producers set levels of output, and prices adjust in relation to supply.  In another model, called Bertrand competition, producers set prices, and produce quantities sufficient to meet demand at the prices they set.  In pure Cournot competition, prices vary substantially based on the number of competitors in the market.  In a Cournot duopoly (a market with two competitors setting output), the producers will between them extract half of a monopoly profit.  But pure Bertrand competition pushes prices down toward marginal costs no matter how many competitors there are.

While the differences between Cournot and Bertrand competition are fundamental concepts of antitrust economics, they seem to have been lost in the race to pin responsibility for rising premiums on concentration in the insurance industry.  While the details of competition among insurers is complex and does not strictly follow any simple model, at a basic level they appear to engage in Bertrand competition for the business of insureds, i.e., they set premiums, and write as many policies as corresponding demand requires.  In this case, we should expect them to compete prices down toward their costs regardless of market concentration.  And we in fact see that insurers’ profit margins are relatively modest despite a longstanding trend of consolidation in the industry.

Providers, on the other hand, seem to engage (again, at a basic level) in Cournot competition.  They produce a given amount of capacity — building hospital beds, hiring physicians — and then negotiate with insurers over the price to use it.  If this is correct, then concentration in the provider market should have a significant impact on the prices that providers can charge insurers, and that insurers ultimately pass on to insureds.  By the same token, concentration in the insurer market should allow insurers to pay lower prices to providers because they are also engaging in Cournot competition on the buy side — they have a certain amount of demand that is set by the needs of their insureds, and they bargain with providers over the price of fulfilling it.  But because insurers are engaged in Bertrand competition on the sell side, they will tend to pass these savings on to their insureds notwithstanding their market concentration.

In this simple model at least, the ideal situation for insureds is to have a concentrated insurance market that approaches Bertrand duopoly on the sell side and Cournot duopsony (two buyers who set demand and take prices) on the buy side, with a competitive market for providers.  Of course, there are complexities — such as product differentiation, switching costs, and homing asymmetries — that can both attenuate and amplify the effect of this basic market structure for consumers, and I hope to address some of them in later posts.  But other things being equal, the implication is clear: concentration in the insurance industry does not necessarily harm and may well benefit consumers, while concentration among providers is a prescription for higher costs.

It has been almost a year since I discovered and embraced the joy of barefoot running.  Even as the East Coast braced for another blizzard, I seized the opportunity of a mild El Niño winter day here in the Pacific Northwest to reel off six miles on my lunch hour in the sneakers God gave me.  In the cold and slop, I compromise with minimalist shoes like Vibram Fivefingers and Feelmax Niesas.  Paradoxically — or so it might seem — since I stopped putting layers of cushioning and stabilizing materials between my foot and the ground, recurring overuse injuries to my hamstrings, calves, and knees that have dogged me for years have simply disappeared.  As I near my one year barefoot/minimalist anniversary, I find myself logging thirty to forty miles a week and more on mostly hard, urban surfaces without pain or discomfort in nothing more than moccasins, and often less.

Like most recent converts to barefoot running, my worldview was tectonically altered by Chris MacDougall’s “Born to Run,” which for me was to fitness what Michael Pollan’s “Omnivore’s Dilemma” was to food.  Woven in to a ripping good yarn about an ultramarathon duel between the preeminent distance runners of industrial civilization and a reclusive tribe of hard-drinking  aboriginal superathletes from the Copper Canyons of Mexico (spoiler alert — the Indians win) is the compelling observation that modern humans had been running long distances barefoot or close to it for a hundred thousand years before the invention of the modern running shoe in the early 1970s.  Packaged with that observation is the suggestion that the explosion of running-related injuries since that “innovation” might not be a coincidence.

Granting MacDougall’s thesis, an interesting economic disconnect is apparent.  If running shoes not only fail to prevent injuries, but in fact cause and exacerbate them, then all the money that is spent on them is worse than wasted.  Yet all that spending is counted as positive economic activity in the most influential measure of our nation’s aggregate welfare, gross domestic product.  And the purchase of running shoes is surely just one of a multitude of transactions that count towards domestic product while contributing little to, and perhaps detracting from, actual welfare.

But snake oil is as old as suckers, and suckers do eventually wise up.  Each scam, fad, or mania, must eventually run its course.  Still, as the proverb says and behavioral economic research shows, there is a sucker born every minute.  So some significant portion of any economy will inevitably be dedicated to the consumption of useless or harmful goods and services.  The gap may be narrowed by consumer protection and education efforts, but it can never be closed.  Knowing this, should maximizing GDP really be the unalloyed objective of economic policy?

This and other incongruities between GDP and actual welfare have motivated various efforts toward specifying alternative measures of beneficial economic activity for some time.  None has yet gained a consensus among academics, much less policymakers.  But in the meantime, as the miles of cool, springy grass and buttery-smooth concrete caress the densely-packed neurons of the soles of my amazing, durable, perfectly-evolved feet, I know that any measure that fails to account for my priceless euphoria cannot motivate policy that is well-calibrated to encouraging the truly excellent life.

I am merely an incidental economist.  In my education and career as an antitrust and patent lawyer, I have been formally trained in and had occasion to apply as much microeconomics and econometrics as is required to understand applied theory of competition and property.  But in macroeconomics, I am as susceptible to enthusiasm and blindness as any autodidact.

Knowing this, I tend to seek and and rely on the consensus of experts.  But unlike, say, in evolutionary biology and climatology, the fundamental controversies in macro do not seem to be largely manufactured by interests and cranks.  The efficient-markets hypothesis, for example, appears to be genuinely and increasingly contested among serious scholars.  Yet should not the recent success of monetary and fiscal intervention in staving off another Great Depression have cemented the Keynesian portion of the neoclassical synthesis?

Lately, I’ve become aware of a number of self-styled “Austrians” who claim that Keynesian policies not only fail to ameliorate business cycles, but in fact, produce them.  It’s an audacious assertion, and one I might trouble myself to investigate if I were convinced that it reflected a serious vein of dissent among professional economists.

Paul Krugman maintains that Austrian business cycle theory is “as worthy of serious study as the phlogiston theory of fire.”  Milton Friedman claimed, less colorfully but no less categorically: “The Hayek-Mises explanation of the business cycle is contradicted by the evidence. It is, I believe, false.”

Am I right to interpret this concurrence of opinion by two Nobelists from opposite ends of the political spectrum as a strong evidence that the Austrian critique is misguided?  Are latter-day Austrians the economic equivalent of creation scientists and climate-change deniers?  Or are there mainstream economists who take them seriously?  And if they do, what does it say about macro as science that there should be basic disagreements about a fundamental object of study in the discipline?

I ran these questions by three professional economists – two university professors and one at the Fed.  As to how many working economists take Austrians seriously, the answers were, respectively, “don’t know,” “don’t know,” and “maybe one percent.”  The one-percenter compared the stature of Austrians in the discipline to that of Marxists.  While the respected Austrian may not be a unicorn, he or she is definitely a snow leopard.

But that doesn’t make the neo-Austrian a crank.  And in point of fact, one of my economists assured me that at least those few self-identified Austrians of whom he knew with jobs in their field accepted (if not loudly) the need for fiscal and monetary stimulus to spur aggregate demand in times of economic crisis.  The real lack of consensus in macro, it seems, is not how to respond to a downturn in the business cycle, but what causes the business cycle in the first place.  And if mainstream macroeconomists agree that the Austrian explanation of this phenomenon is demonstrably lacking, it is not because they have a well-supported alternative or viable research program of their own.

Today’s Austrians may be a small and dubious minority.  But they have hardly opposed themselves to the edifice of a successful science.

There are good political and policy reasons for Congressional Democrats to pass the Senate Health Care Bill, hopefully with a reconciliation “sidecar,” but without one if need be.  But I have a personal reason for my desperate wish to see the Senate Bill enacted.  My daughter has autism.

In most states, including my home state of Washington, it is legal for insurers to discriminate against autistic insureds by excluding or severely restricting necessary therapy for their condition.  For example, we are eligible for reimbursement of only sixty therapy visits a year under our current insurance, a fraction of the over two-hundred that our daughter needs.

Providing adequate therapy and meeting the other medical needs of her condition costs us around $20,000 per year out of pocket.  This is on top of the more than $1300 monthly premium that we have been paying through COBRA for our otherwise pretty good, non-profit public-employee health plan since my wife left full-time employment with the state to work part time from home as a contractor in order to spend more time caring for our daughter.

When COBRA runs out, however, we will be in a far worse predicament.  Our current plan at least covers diagnostic medical services for the team of doctors, nurses, and psychologists who help to design our daughter’s treatment and manage her medication, as well as for costly genetic screening and other testing to examine potential causes.  But the group policy that my law firm provides to its employees has even more restrictive limits on therapy visits and diagnostic coverage.

And because I am a partner in my firm (and thus a self-employed part owner of the business), I would have to pay the entire $1800 monthly premium, which has been rising annually by double-digit percentages even as benefits have deteriorated.  Plans in the individual market cost less, but they offer little in the way of autism benefits when they offer any at all.

The Senate Bill would outlaw autism insurance discrimination nationwide by requiring that autism coverage be included in the basic benefits package.  Without it, I truly do not know what we will do when our current coverage runs out.

I have been away from blogging the last few weeks, devoting my discretionary writing and thinking time to preparing a speech commemorating the Immortal Memory of the great Scottish poet Robert Burns, whose birthday is today, and is celebrated each year at Burns Suppers around the world.  My speech this year, delivered at a Burns Supper on Saturday, touched on a diverse topics, including tattoos, absinthe and extreme metal music. (Really!). But I am writing about it here, because in the course of my research I was surprised to learn that Burns was an incidental economist of sorts.

I suppose I had long been vaguely aware that Burns and Adam Smith were countrymen and contemporaries. But I had not known that they were mutual admirers, much less that Burns had modeled one of his most famous rhymes on a passage from Smith.

In “The Theory of the Moral Sentiments,” Smith argued that human conduct would surely improve if we could become “impartial observers” of ourselves:

Self-deceit, this fatal weakness of Mankind is the source of half the disorders of human life.  If we saw ourselves in the light in which others see us, or in which they would see us if they knew all, a reformation would generally be unavoidable.  We could not otherwise endure the sight.

This notion crowns the poem “To a Louse,” in which Burns, contemplating a well turned-out lady at church who does not realize that a parasite is quite publicly creeping up her Sunday bonnet, proclaims (in Scots dialect):

O wad some power the giftie gie us
To see oursels as ithers see us

Now if only this power were given to the House Democrats, who can’t seem to understand that they have become political laughingstocks for their apparent inability to pass the Senate health care bill, with or without improvements through reconciliation, declare victory, and move on.

Occasionally, an antitrust complaint comes along that is just a ripping good read, perhaps even for a non-lawyer.  The Federal Trade Commission’s recent complaint against Intel is just such a one.  It depicts a litany of strong-arm tactics and deception that the FTC claims has frustrated the ability of Intel’s few competitors to bring faster, cheaper microprocessors to consumers.

But what is most interesting to me as a lawyer is not what the FTC has alleged Intel did, but why it has claimed that conduct is illegal.  For the FTC has not just challenged Intel’s conduct under the main monopoly statute, Section 2 of the Sherman Act, under which private suits and actions by the Department of Justice are also brought, but also under a special unfair competition statute, Section 5 of the FTC Act, that is only available in actions by the FTC.

Unfair competition under Section 5 of the FTC Act is ostensibly broader than monopolization under Sherman Act, though the FTC has had limited success in the past enforcing it against conduct that was not also an antitrust violation.  Since those setbacks, however, courts have limited the scope of the antitrust laws on both economic and prudential grounds.  “The result,” according to a statement by FTC Chairman Leibowitz and Commissioner Rosch, “is that some conduct harmful to consumers may be given a “free pass” under antitrust jurisprudence . . . .”

A separate statement by Commissioner Rosch identifies several examples of how courts have curtailed antitrust enforcement against conduct that may be harmful to consumers:

• Courts frequently admonish that the antitrust laws protect competition, not competitors.  But in a highly concentrated market, harm to competitors may itself harm competition.
• Courts are often reluctant to condemn practices that decrease innovation without necessarily raising prices.  But decreased innovation can harm consumer welfare every bit as much as monopoly pricing.
• Many courts have disparaged as “mere monopoly broth” claims based on a course of conduct whose constituent elements do not each themselves amount to antitrust violations.  But acts that by themselves may be innocuous may have consequences in conjunction that are greater than the sum of their individual effects.
• Some cases have suggested that a monopolist’s intent is not relevant to the legality of its conduct.  But what the monopolist hoped to achieve may be a very good indicator both of the likely consequences of its actions, and of the plausibility of its justifications for undertaking them.

In bringing unfair competition as well as monopolization claims against Intel, the FTC is setting up a test of its enforcement authority against harmful conduct that the lately-diminished antitrust laws may not reach.  As an advocate of vigorous antitrust enforcement, I am not sure if I am more heartened by the FTC’s broad assertion of its mandate than I am discouraged at its acknowledgment that the state of the antitrust laws may have made that assertion necessary.